FreeMarketDuck.com

Idaho's Weekly Journal of Local & National Commentary Week
2815

Washington, DC – With the Federal Reserve’s
wide-ranging efforts to address the ongoing Credit Crisis through
unprecedented money-creation activities, we are now likely witnessing the
final phases of the U.S. Dollar’s 64-year reign as the primary global
reserve currency. Few Americans understand the implications of this
dramatically unfolding global sea-change.

The U.S. Dollar was installed as
the lynchpin of the international monetary system in July 1944 by and among
the 44 Allied nations, and just as the end of WWII was in sight. At that
time, the U.S. owned or controlled well over half of the world’s wealth, and
the Bretton Woods Agreement (named after the small town in New Hampshire
where over 700 representatives of the leading industrialized nations met
that summer) created the financial architecture whereby the U.S. Dollar, as
backed by and exchangeable into gold at the rate of $35/oz, would function
as principal 'reserve currency' in the post-war global monetary system. The
dollar debuted in its newly-expanded role via the Marshall Plan and the
reconstruction of post-war Europe, when the U.S. paid dollars into the
accounts of foreign banks, both to maintain our overseas military bases as
well as to rebuild war-ravaged economies. Very importantly, all crude oil
transactions throughout the world were also designated to be priced in
dollars, regardless of which nations participated in the oil trades. In many
ways, the Bretton Woods Agreement can be seen as one of the great 'spoils of
war' for the U.S., and the dollar’s acceptance and dominance was subtly
reinforced throughout the subsequent Cold War and afterwards by America’s
enduring global military supremacy – the so-called 'Pax Americana.'

Bretton Woods thus represented
an enormous post-War economic advantage for America ever since, yet in
mirror fashion it emerged as a major problem for the other countries,
primarily because it created the possibility that the dominant U.S. could
simply print money, and do so essentially at the expense of diluting the
other nations' savings. Gold convertibility was to provide the discipline
whereby the U.S., as keeper of the 'reserve currency,' would keep its budget
in balance and the dollar as a sound reserve currency. That is, if other
nations were uncomfortable with the U.S. spending policies which might
dilute the value of their reserve savings, they could convert their dollar
savings into gold. But Bretton Woods allowed the U.S. some convenient
'wiggle room.' Over time, the U.S. chose a predictable political path in
ignoring key parts of the Agreement, often reminding the less-powerful
Europeans who had saved them from the Nazis, who had won WWII, and who was
now protecting them from the rising Soviet menace. In due course of the
post-World War II era, the U.S. began to spend far beyond its means both for
defense and foreign aid purposes, as well as for expanding domestic social
programs.

By the 1950’s the U.S. undertook
the expensive Korean War, and then in the 1960s the U.S. began to spend in
earnest for both the Vietnam War as well as for President Lyndon Johnson's
'Great Society' welfare and entitlement programs. These activities were
essentially financed by creating new debt and/or new inflated dollars, and
these efforts served to plant the seeds for significant dilution and
debasement of the other countries’ U.S. Dollar reserve accounts.

The era of ballooning U.S.
deficit spending and rising inflation was well underway by the late 1960s.
Over time, the Bretton Woods participants became increasingly frustrated
about the debasement of their dollar reserve savings, and French President
Charles de Gaulle even announced his intention to send a ship to the U.S. to
exchange France’s accumulated U.S. Dollars for gold at the official rate of
$35/oz. By 1971, the other European nations were also increasingly
uncomfortable, yet the dominant U.S. first downplayed and then later
summarily dismissed their concerns through President Richard M. Nixon, when
the U.S. officially and unilaterally suspended the gold-convertibility
'promise' of Bretton Woods. In officially closing the so-called 'Gold
Window’ on August 15, 1971, Nixon's Treasury Secretary John B. Connally
rebuffed the Europeans with his now-famous quote: "The dollar is our
currency, but it is your problem." So foreign central banks took it badly on
both ends – they were unable to keep Congress and the U.S. from spending
programs which were diluting their 'dollar reserve currency' savings, and
they were also unable to redeem their dollars for gold as promised.

With Nixon’s official
abandonment of the Bretton Woods gold-convertibility system, the global
economy moved thereafter to a 'floating' exchange-rate system where currency
rates were no longer fixed against each other and/or backed by gold. The
currency world entered a new and more speculative ‘Relativistic Age’ where
currency exchange rates instead varied constantly, depending on changing
perceptions of the strength of one another’s economies, and especially
reflecting their comparative internal structures of interest rates. With the
emerging need to 're-cycle' petrodollars following the Arab Oil Embargo of
1973, and with dollar fundamentals further weakened by continuing frequent
U.S. trade and budget deficits since the Vietnam era, the global economy
became increasingly awash in dollars by the late 1970s. With oil price
shocks and deficit-spending combining to produce double-digit inflation by
1979, a 'dollar rescue' of sorts developed in 1980, when U.S. Fed Chairman
Paul Volcker dramatically raised Fed Funds rates, eventually pushing the
Prime Rate to 21 1/2% by late 1981. Volcker’s Fed tenure represented a
painful adjustment period for the U.S. economy, but it won the U.S. great
praise around the world for bringing inflation under control. Unfortunately
for dollar-holders, the Volcker Era did not last.

With escalating social and
military spending through the Cold War, plus the dramatic increase in the
'Star Wars' military budgets during the Reagan Administration, the reasons
occasionally varied but America’s core political focus remained on greater
deficit spending, more borrowing, and a resulting deterioration of the
dollar’s fundamentals.

The U.S., admired widely for
decades as the ‘Wealthiest Nation on Earth,' quietly transitioned from being
a 'net lender' nation to a ‘net borrower’ nation in 1983. By 1985, U.S.
Treasury Secretary James A. Baker III initiated the ‘Plaza Accords’ among
the so-called ‘G-5’ countries, whereby foreign central banks coordinated to
reduce dramatically the floating exchange rate of the dollar. Spending for
defense and major declared wars through the 1980’s transitioned after the
collapse of the Soviet Union to spending for lesser undeclared wars against
terrorism and various other perceived regional threats in Panama, Granada,
Libya, and Somalia, and later in Afghanistan and Iraq. During the late
1980’s and early 1990’s, the U.S. Republican-led conservative movement
produced another noteworthy rescue round of ‘sound money’ initiatives which
had been championed by U.S. Speaker of the House Newt Gingrich, but these
'Balanced Budget' efforts were eventually abandoned under the relentless
political pressures of spending to attract votes for defense and for
continuing social programs.

The U.S. now ranks as the #1
borrower in the world, and our cumulative National Debt now stands at nearly
$9.4 Trillion at this writing. The annual net deficits have risen ever
faster since the World Trade Center Disaster in 2001, which produced the
reactionary ‘anti-terror’ wars in Afghanistan and Iraq starting in 2001 and
2003. Since 2006, America’s major trading partners and foreign lenders have
been asked to finance these expanding deficits by investing in new U.S. debt
at rates now approaching $1 Trillion per year. More recently the global
Credit Crisis has produced an even faster rate of deficit money-creation by
the Fed. With America’s history of deficit spending, plus a weakening U.S.
economy which no longer drives the global ‘growth engine,’ and now adding
the final coup de grace of the exported sub-prime syndication
contagion, foreign central banks have moved aggressively to diversify out of
exclusively dollar-denominated savings. The dollar has clearly lost its core
attraction as the reserve currency of choice of the world. With the
successful 2001 debut of the Euro and its growing acceptance by major
industrialized nations as an alternative currency, the tipping point of
other countries’ willingness to accept the dollar as the primary global
reserve currency may be approaching.

America has now grown accustomed
to borrowing from abroad to support its wars, its domestic programs, its
comfortable lifestyle, and its dependence on foreign crude oil. Global
investors have so far remained willing to lend to us based on our global
economic dominance and the perception of the U.S. as a perennial safe haven
for investments. But the cumulative borrowing over the past decades has now
escalated to dangerous levels, especially compared to our dramatically
weakening growth rates in comparison to other emerging economies such as
China and India. International investors have grown less willing to finance
America’s spendthrift habits and reckless foreign policy. With current
‘real’ U.S. inflation rates of 9% or so easily exceeding the sub-4% interest
rates earned on U.S. Treasuries, global investors clearly have more
attractive other investment options to consider.

The Credit Crisis has added a
greater sense of urgency to the dialogue of the continuing role of the
dollar. Since August 2007, the Fed has battled the sub-prime and derivative
credit crises with a wide array of new ‘fiat’ money-creation weapons - now
aggressively expanded to include new ‘liquidity injections,’ swaps, bond
auctions, the Exchange Stabilization Fund, the Plunge Protection Team, the
Bear Stearns direct lending rescue, ‘Term Securities Lending Facilities,’
collateralized purchases of credit card, auto loan & student loan
portfolios, plus even hints of the Fed engaging in outright corporate
recapitalization activities. These emergency Fed actions, often in concert
with the European Central Bank and the Bank of England, have temporarily
stabilized a chaotic scene, but at the expense of adding even further to the
escalating weaknesses in the dollar.

The Fed’s recent spectacular
levels of ‘instantaneous’ money-creation should produce additional major
dollar-dilution and forward inflation - and these deepening problems arrive
after the dollar has already
lost 50% of its value against the Euro since 2002 alone. The world economy
appears to be witnessing something akin to a developing ‘death-spiral’ of
the dollar, as OPEC nations now seek to raise their dollar-based oil prices
to keep ahead of increasing U.S. inflation rates, while these reactionary
price increases only escalate a still-further up-cycling of inflation. Since
2002, the dollar prices of other worldwide commodities including metals and
key raw industrial materials, as well as critical wheat, corn and rice food
staples, have likewise risen 3 to 7-fold in concert with oil. While
monetary inflation lies at the core of any price inflation, rising global
standards of living, tightening supplies, power & water shortages and the
occasional influences of Mother Nature in many of these markets may all
serve to exacerbate these developing inflationary trends.

With the added emergence of the
sub-prime crisis and the exporting of these infected mortgage portfolios and
their derivative problems around the globe, the rest of the world is even
more wary of dollars and dollar-denominated assets. But if not the dollar as
the global reserve currency, what else? Commodities in general plus the
precious metals group of gold, silver and platinum in particular have
witnessed major run-ups, as investors look to buy ‘things’ rather than ‘U.S.
Federal Reserve Obligations’ as more attractive alternatives to the steadily
weakening dollar. Over the past few years, world markets have also seen the
emergence of ‘Sovereign Wealth Funds,’ whereby individual nations have
dedicated their trade and payments surpluses to funds investing in
Euro-denominated assets, public companies and various commodities as
alternatives to weakening dollar-denominated assets and other paper
currencies. China, for example, has moved aggressively in Africa, South
America and elsewhere to secure major raw materials contracts, as well to
buy the companies which produce them. Other Middle Eastern, OPEC countries
and emerging nations have similarly created sovereign wealth funds in their
national interests, and many have used them as away to diversify out of
dollars.

The activities of the U.S. Fed since August
2007 promise a continuation of the inflationary trends noted below, and
there appears to be another major upswing in inflation just ahead as the
Fed’s massive money-creating actions since August 2007 work their way from
Wall Street and into the global financial system.

Representative Commodities Price
Comparisons 2003 vs 2008

2003

2008

$2.25

Corn

$6.10

$3.20

Wheat

$8.50 (U.S. stockpiles now
lowest since WWII)

$3.00

Rice

$21.00 (Primary food source
for 1/3 of the world’s population)

$27.00

Crude Oil

$125.00

$4.60

Silver

$17.00

$340.00

Gold

$885.00

$1.05

Euro

$1.55

The Arab world has occasionally expressed its
concerns about the falling dollar, and a few specific Arab states have
attempted in recent years to ‘de-couple’ crude oil from being priced in
depreciating dollars. Aspiring powers take note, invariably the U.S. has
responded subtly (and indirectly) by sending Vice President Dick Cheney and
yet another carrier to the Persian Gulf. But China and our other major
trading partners are also unhappy with being ‘forced’ to accept trade
dollars and convert them into steadily-depreciating U.S. Treasuries. Our
major trading partners and the OPEC nations currently invest nearly $1
Trillion in new financing each year to support our ever-growing trade and
spending deficits, and the severe troubles on Wall Street have deepened
their concerns about investing in depreciating dollar assets. With the Bush
Administration still enforcing an out-of-balance game of geopolitical
hardball, something has to give, and possibly soon.

A new stable global ‘reserve currency’ is
needed to correct these global trade, exchange and financing imbalances, and
to replace the faltering U.S. Dollar. What is needed is a new ‘reserve
currency’ which also provides a more stable medium of exchange, and this
concept is apparently in the works. The globally-accepted Euro now
constitutes a qualified new ‘reserve currency’ candidate, but it also can be
undermined by political spending flaws. In April 2008, global billionaire
financier and currency speculator George Soros commented at the European
Policy Studies think tank, “I don’t think that the Euro can replace the
dollar, and a system with two major reserve currencies is not a stable
system….The Euro, while it is obviously an alternative, is not a truly
attractive alternative, and therefore there’s a general flight from
currencies.” Soros continued on National Public Radio in May: “We
are in the midst of the worst financial crisis since the 1930s…In
some ways, [this crisis] resembles other crises that have occurred in the
last 25 years, but there is a profound difference: The current crisis marks
the end of an era of credit expansion based on the dollar as the
international reserve currency…A new paradigm is needed.” Gold and precious
metals may help to shape that new paradigm of replacing and/or backing
faltering paper currencies.

Gold has been prized as money by virtually
every major civilization in world history, and it has utilized as a stable
reserve currency many times before in European, British and American
history. As a rare and virtually indestructible metal, gold has served
repeatedly over the centuries virtually a class by itself as an effective
medium of exchange, yet it has also been periodically abandoned, ignored or
shunted aside by politicians who resent its fiscal discipline when they want
to spend more money to attract votes, or to pay for perceived military,
terrorist or financial threats. The last 37 years since the demise of
Bretton Woods has constituted just one of those periods where gold was
rejected or ignored, but as usual it keeps resurfacing as an unmistakable
store of value which cannot be printed out of thin air by governments. With
the Fed’s pursuit of spectacular money-creation policies which will
unmistakably lead to the further undermining of the dollar, gold again lies
waiting in the wings to return to its time-tested role as a stable medium of
exchange and reserve currency.

Nothwithstanding the official ‘disdain’
toward gold in recent decades, neither the U.S. nor the Europeans have ever
truly abandoned it. Enormous gold reserves have remained quietly and
unobtrusively on the balance sheets of the Federal Reserve Bank, the Bank of
England, the European Central Bank, the International Monetary Fund, and the
Bank for International Settlements, and a reactivation and revaluation of
gold, such as occurred during the Great Depression in March, 1933 under
President Franklin D. Roosevelt, may offer a true solution to the unfolding
global Credit Crisis. In March 2008, shortly after the Bear Stearns bailout,
former Dallas Fed Governor Robert McTeer commented notably on CNBC, "Gold is
the ultimate store of value in any financial system." It may now take one
more inflationary wave or another financial crisis of unknown dimensions to
finish the job and to usher in a new global era, perhaps restoring gold
convertibility to the global reserve currency equation.

What lies ahead? The world economy and
balance of trade among major trading partners with China and the OPEC
countries are seriously out of alignment, and a financial crisis and
resulting re-alignment seems inevitable. The foreign central banks have now
joined the Fed in spectacular money creation to inflate past the sub-prime
problems, and a stronger prospect remains for a global inflationary
upheaval, a major re-alignment of global currencies, and probably a period
of harder times for America. The U.S. will likely need to shift from being a
‘consuming nation’ back to an era of Americans as thrifty savers.(Retailers
take note.) Just imagine what will happen to the U.S. economy when we are no
longer able to ‘induce’ foreigners to provide us $1 Trillion per year in
deficit financing as we are doing today, and when that incremental $1
Trillion is not here to turn over a few times each year inside our
economy.(Retailers and everyone take note.) There will very likely be a
period of painful adjustment for the U.S. as we are forced to tighten our
belts and to modify the era of ‘U.S. as Net Consumer to the World.’

Notwithstanding the recent more hopeful
attitude on Wall Street, the August 2007 Credit Crisis which began with
overvalued mortgage portfolios will likely continue throughout 2008 and
beyond. The multi-trillion dollar ‘housing bubble’ was built on steadily
increasing housing values, yet real estate markets will clearly see
declining home values for some time ahead. There is a significant
likelihood, reinforced by the Fed’s recent expanded actions to buy up
distressed auto, credit card, and student loan portfolios, that the
sub-prime contagion is spreading to other sectors. The pressure may be off
in the short term, but the fundamental problems of downward-spiralling asset
portfolios and ‘mark-to-market’ accounting valuations still loom. As housing
values erode and defaults & foreclosures increase, more massive loan
portfolio write-downs, along with potentially even greater losses in the
financial derivatives arena, lie just ahead in the shadows.

With the Bear Stearns rescue precedent, the
imminent threat facing Wall Street financial institutions appears to have
been abated, at least for the moment. The emerging reality is that the Fed
has transformed a short-term crisis threatening a group of large financial
institutions into a longer-term and eventually more destructive inflationary
spiral to be borne by the average taxpayer, and where the average American’s
meager savings may be all but wiped out in the end. A weakening economy with
declining home prices and credit availability, coupled with strongly
increasing prices for food, gasoline and the necessities of life promise
trouble ahead. Our European friends may know just what these things mean
from their hyperinflationary experiences in the 1930’s, and they know just
how severe those consequences may be for all of us.

If the Fed consistently creates new liquidity
and money to wallpaper over our problems, the dollar cannot help but be
debased even further. Notwithstanding any occasional confusions as to the
true causes of inflation, massive money creation on Wall Street inevitably
will produce price inflation in the heartland. Dollar holders should clearly
beware, as the Fed has clearly opened wide the floodgates of the inflation
dam upstream, and a flood of money may soon engulf the financial landscape.
Purchasing power will slip underwater first, and unwary fixed dollar savers
may likely drown in this unfolding scenario.

The Fed may have telegraphed that massive
money-inflation was coming in March 2006, when it abruptly discontinued its
weekly release of the widely-followed Money Supply data. As John Lee’s chart
indicates below, M3, the widest measure of the U.S. money supply data, had
increased over 1500% from 1970-2006. With the Fed’s Credit Crisis responses
since last August, these numbers have likely accelerated even further, and
by some estimates the money supply growth is now running as high as 10 times
even the prior 2006 rates. The U.S. Labor Department’s Bureau of Labor
Statistics ‘official’ March 2008 CPI-U inflation rate of 3.98% (which
somehow carefully omits the 69% increase in food prices over the past year
as well as soaring energy costs) almost surely understates real ‘on the
street’ inflation by a very wide margin. Even more troubling to the
statistical purists who follow official inflation indicators, the U.S.
Commerce.

Department and BLS recently announced key
staff cutbacks in their critical data production areas. Although the core
statistics may now be more difficult to find, the average American can see
and feel the new reality of inflation, and there promises to be plenty more
ahead where that came from. The Fed’s recent massive money-creation on Wall
Street will produce even greater price inflation on Main Street in due
course, and perhaps surprisingly soon.

A picture is worth a thousand words and the
chart above is no different. There is 1,500% more paper money today than
there was in 1970. (Chart and comment courtesy John Lee, CFA/www.goldmau.com)

Competitive economic infrastructures have now
been built in Japan, China, India and elsewhere, and the U.S. no longer
controls global resources as it once did. But the U.S. still has options and
opportunities, and no country has broader or deeper resources, or does a
better job of implementing new ideas and concepts and technologies than we
do. It is very possible that an entirely new and more stable global economic
system may soon re-emerge, featuring a new U.S. energy policy as well as
pioneering U.S. nanotechnology and biotechnology developments as commercial
centerpieces. Given the inherent weakness of floating paper currencies which
can be created virtually at will by pandering, ambitious or reactionary
politicians and their allied central banks, the solution to budget deficits,
global trade imbalances and overall economic stability could very well
include some form of renewed official currency convertibility into gold.
Gold has represented sound money for thousands of years, and its rightful
place may be re-emerging as a beacon of stability in a world which grows
more wary and sea-sick of the floating U. S. Dollar with each new crisis.
Uncle Sam has captained the global reserve currency ship alone for 64 years,
and the sea-change replacement of the U.S. Dollar may lie just ahead.